How Much Do You Need?
Unless you have an excellent pension plan that can cover all your income needs during retirement, you will ask sooner or later: “Do I have enough savings for retirement?”
First, let’s define what the “Sustainable Withdrawal Rate” (SWR) is. SWR is the maximum amount of money that you can withdraw from savings throughout retirement with an acceptable risk of depletion. It is customary to express it in terms of a percentage, such as the famous “4% rule”. This rule suggests that if you start withdrawing the dollar amount that is equal to 4% of retirement assets at the beginning of retirement and then index these withdrawals to the Consumer Price Index (CPI) throughout retirement, then you would have income for 30 years at a reasonable risk.
The important question is: “What is acceptable risk?” The answer makes a big difference in SWR and how much savings you need for retirement. What is acceptable depends on what this money is needed for: Do you need this money to buy your groceries or is it to help your grandchild for her overseas vacation? So, we place each expense item into one of these three groups: Essential, Basic, and Discretionary.
Essential Expenses:
These are expenses that are necessary for survival. Generally, housing expenses, income taxes and most living expenses are in this group. Here, we define acceptable risk as: “the occasional loss of purchasing power must not be larger than 10% at any age”.
Basic Expenses:
These are lifestyle expenses that that are not critical for survival. For example, if you love going south each winter, when push comes to shove (financially), you can probably do without it. Here, our acceptable risk is: “the probability of portfolio depletion should not exceed 10%” during your retirement.
Discretionary Expenses:
You are flexible with these expenses. Donations, multiple vacation homes, financial assistance to relatives, usually belong to this group. Here, the acceptable risk is: “the median outcome must last until death”, i.e. there is a 50% probability of portfolio depletion at death.
Going back to our important question, the first step is to make a list of all your expenses which is the easy part. The difficult part is to decide (and agree with your spouse) which are essential and which are not. No one else will do this for you. For example: having two cars may be essential for some. For others, having one car may be a discretionary expense. Another example: helping with a grandchild’s expenses can be a discretionary expense, but helping with a disabled grandchild’s expenses can be essential. Make the list, categorize each expense item, and then discuss with your spouse to make sure it is entered in the correct group. To make this process easier, use the cash flow worksheet template at my website if you want.
The next step is to make a list of all expected retirement income from all sources. This list should include income from Canada Pension Plan (CPP), Old Age Security (OAS), company pensions, annuity income, rental income, business income, royalties, and so on. Do not include income from investments (open or registered) because it is calculated separately using the SWR.
The SWR table on the next page is based on a “buy-and-hold” portfolio, with an asset mix of 40% equities, 60% fixed income (and cash), rebalanced annually, time horizon until age 96.
Now, we can demonstrate “Do I have sufficient savings for retirement?” with an example:
Ron and Ann are both 65, just retiring. They have combined retirement assets of $680,000. Their combined government benefits CPP and OAS are $35,000 per year. In addition, Ann has an indexed pension that pays $23,000 per year.
Their total annual expenses are $80,000; $40,000 for essential, $35,000 for basic, and $5,000 for discretionary expenses.
Essential Expenses:
Their income from other sources (CPP, OAS and pension) add up to $58,000 (calculated as $35,000 plus $23,000). Their essential expenses are $40,000. Ron and Ann don’t need any savings to meet their essential expenses because income from other sources pay their essential expenses in full, and we carry forward the surplus of $18,000 towards their basic expenses (calculated as $58,000 less $40,000).
Basic Expenses:
Their basic expenses are $35,000. The surplus of $18,000 that we carried forward pays part of it. They need an additional $17,000 from their retirement assets (calculated as $35,000 - $18,000) to cover their basic expenses.
From the table above, SWR for basic expenses at age 65 is 3.82%. Divide $17,000 by 3.82% to calculate how much assets they need for their basic expenses: $17,000 / 0.0382 = $445,026
Discretionary Expenses:
Their discretionary expenses are $5,000 per year. From the Table above, SWR for discretionary expenses at age 65 is 5.03%. Divide $5,000 by 5.03% to calculate how much assets they need for discretionary expenses $5,000 / 0.0503 = $99,404
They need total of $544,430 (calculated as $445,026 plus $99,404). They have $680,000. So, they have sufficient savings cover their retirement expenses.
I hope this example helps you to answer your “Do I have enough?” question.
Jim C. Otar is a retired advisor living half of the year in Thornhill and the other half in Niagara. www.retirementoptimizer.com